An index is a collection or portfolio of stocks, bonds or other investments (referred to herein as “investment assets” or “assets”) selected to represent a particular segment of a market. The representative assets selected defined the investments in the index. Methodologies for administering indices include rules for weighting the constituents in the index and rules for maintenance of the index when constituents of the index change. Indices can be defined by the kinds of investments included, such as stock indices, bond indices, and commodity indices, etc. Indices can also be defined by the schemes used to weight the constituents of the index, such as capitalization (“cap”) weighted, price weighted, and equal weighted. Exemplary indices used in the market include the Standard & Poor's (“S&P”) 500, the S&P Global 1200, the S&P/Citigroup indices, MSCI's indices, FTSE's indices, and Russell's indices.
In a capitalization weighted index, each constituent stock's weight in the index is its capitalization compared to the sum of all the stocks' capitalizations. The simplest capitalization weighted index can be thought of as a portfolio consisting of all the available shares of the stocks included in the index. While one might track this portfolio's value in dollar terms, it would probably be an unwieldy number—the S&P 500 market value is roughly $11 trillion. Rather than deal with ten or more digits, the figure is scaled to a more easily handled number, currently around 1300. The scaling is done by dividing the portfolio market value by a factor, usually called the divisor.
An index is not exactly the same as a portfolio. For instance, when a stock is added to or deleted from an index, the index level should not jump up or drop down. A portfolio's value, on the other hand, would usually change if stocks are swapped in and out. To assure than the index's value, or level, does not change when stocks are added or deleted, the divisor is adjusted to offset the change in market value of the index. Thus the divisor plays a critical role in the index's ability to provide a continuous measure of market valuation in the face of changes to the stocks included in the index. In a similar manner, some corporate actions which cause changes in the market value of the stocks in an index should not be reflected in the index level. Adjustments can be made to the divisor to eliminate the impact of these corporate actions.
Investment index solutions provide a basis for categorizing and grouping investment assets (e.g., stocks) according to predefined characteristics of the assets. For example, assets may be characterized and grouped in accordance with each asset's “style”—that is, whether the asset is characterized as a value investment or a growth investment. A value stock is a stock that is considered undervalued because it tends to trade at a lower price relative to it's fundamentals (i.e. dividends, earnings, sales, etc.). Common characteristics of such stocks include a high dividend yield, low price-to-book ratio, and/or low price-to-earnings ratio. A growth stock is the stock of a company whose earnings and/or sales are expected to grow at an above average rate relative to the market. Size of the underlying company is another example of a characteristic style.
Style index solutions should address two distinct needs. The first is for exhaustive style indices that can effectively form the basis for index funds and derivatives, providing broad, cost-efficient exposure to a certain style segment. The second need is for narrow, style-pure indices that provide a pure style return series, and serve as the basis for style-concentrated investment vehicles or ‘style spread’ products.
There should also be consistency between the style definition used in index-driven, returns-based style analysis and style definitions used at the stock level, in equity research and holdings-based style analysis.
This disclosure describes a comprehensive style index solution that includes building separate style and pure-style indices and provides a consistent set of stock-level style scores and style indices.
In one embodiment, an asset's value characteristics and growth characteristics are measured in separate dimensions using factors that have been found to be indicative of the asset's growth or value tendencies.
The Style Index series divides the complete market capitalization of a group of investment assets approximately equally into value and growth indices. This series covers all stocks in a parent index universe, and uses the conventional, cost-efficient market capitalization-weighting scheme. Any asset that does not fall into pure style baskets (e.g., pure growth or pure value) has its market capitalization distributed between value and growth indices.
The Pure Style Index series identifies approximately one third of the parent index's market cap as pure growth and one third as pure value. There are no overlapping stocks, and these indices do not have the size bias induced by market capitalization weighting. Rather, stocks are weighted in proportion to their relative style attractiveness.
Style-based Indices can be available for various style subsets of wider indices, such as the S&P 500, S&P MidCap 400, S&P SmallCap 600, and their various combinations.
According to one embodiment, scores will be reviewed and indices rebalanced every December so as to coincide with the real world portfolio review process, which typically relies on year-end evaluations.
In investigating and evaluating industry practices on issues surrounding style index construction and usage, two defining trends have emerged in recent years.
1. Equity style indices should address two distinct sets of market participant needs.
A. The first need is for conventional broad-based, exhaustive style indices that can effectively form the basis for index funds and exchange-traded derivatives, providing cost-efficient exposure to a certain style segment. These indices are market capitalization-weighted because this weighting scheme is cost-efficient, and provides mean variance-optimized exposure to the market.
B. The second need is for narrower, style-pure indices which provide quantitative analysts and performance analysts with a pure style return series, while also providing the basis for style-concentrated investment vehicles and style spread-based structured products. These indices' returns should not suffer from size bias induced by market capitalization weighting, but rather should reflect the structure of active managers' portfolios, which hold stocks in proportion to their relative attractiveness.
While a variety of indices cater to the first need, the second need is clearly not satisfied by existing style indices from major index providers.
2. Use of multiple measures of equity risk and more sophisticated quantitative techniques has become the norm in style analysis.
Increased availability of financial databases and a proliferation of portfolio risk software have resulted in style being analyzed across multiple risk factors, in contrast to the simple three-factor risk measure in the Fama-French world.
Returns-based style analysis is increasingly being supported by holdings-based style analysis, making it imperative to have inter-operability between the style definitions being used at the stock level and at the benchmark construction level.
While style indices and holdings or returns-based style analysis tools are readily available, there is no consistency of style definition used for leading style indices and style definitions used at the stock level.
Taking into account the above-described trends, the goals of an index design methodology in accordance with an embodiment of the present invention are as follows:
A group of candidate assets are assembled, and the value and growth characteristics of each assets are evaluated at the stock level along separate dimensions using multiple factors. Using the results of this evaluation, two sets of complementary index series are constructed:
Style Index series—This series divides the complete market capitalization of the group of candidate assets approximately equally into value and growth indices while limiting the number of stocks that overlap between them. This series is to be exhaustive (i.e., cover all assets (e.g., stocks) in the candidate asset group) and use the conventional, cost-efficient market cap-weighting scheme.
Pure Style Index Series—This series is based on identifying a predefined portion—for example, approximately a third—of the market capitalization of the candidate group as pure growth and a third as pure value. There will be no overlapping stocks, and stocks are weighted by their style attractiveness.